The Global Financial Crisis (The Lehman Brothers Bankruptcy 2007-2009)

Background:
The global financial crisis, brewing for a while, really started to show its effects in the middle of 2007 and into
2008. Around the world stock markets have fallen, large financial institutions have collapsed or been bought
out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their
financial systems all thanks to the collapse of The Lehman Brothers, a sprawling global bank, in September
2008 which almost brought down the worlds financial system.
It took huge taxpayer-financed bail-outs to shore up the industry. Even so, the ensuing credit crunch
turned what was already a nasty downturn into the worst recession in 80 years. Massive monetary and fiscal
stimulus prevented a depression, but the recovery remains feeble compared with previous post-war upturns.
GDP is still below its pre-crisis peak in many rich countries, especially in Europe, where the financial crisis
has evolved into the euro crisis. The effects of the crash are still rippling through the world economy: witness
the wobbles in financial markets as Americas Federal Reserve prepares to scale back its effort to pep up
growth by buying bonds.
With half a decades hindsight, it is clear the crisis had multiple causes. The most obvious is the
financiers themselvesespecially the irrationally exuberant Anglo-Saxon sort, who claimed to have found a
way to banish risk when in fact they had simply lost track of it. Central bankers and other regulators also
bear blame, for it was they who tolerated this folly. The macroeconomic backdrop was important, too. The
Great Moderationyears of low inflation and stable growthfostered complacency and risk-taking. A
savings glut in Asia pushed down global interest rates. Some research also implicates European banks,
which borrowed greedily in American money markets before the crisis and used the funds to buy dodgy
securities. All these factors came together to foster a surge of debt in what seemed to have become a less risky
world.
The years before the crisis saw a flood of irresponsible mortgage lending in America. Loans were
doled out to subprime borrowers with poor credit histories who struggled to repay them. These risky
mortgages were passed on to financial engineers at the big banks, who turned them into supposedly low-risk
securities by putting large numbers of them together in pools. Pooling works when the risks of each loan are
uncorrelated. The big banks argued that the property markets in different American cities would rise and fall
independently of one another. But this proved wrong. Starting in 2006, America suffered a nationwide houseprice slump.
The pooled mortgages were used to back securities known as collateralised debt obligations (CDOs),
which were sliced into tranches by degree of exposure to default. Investors bought the safer tranches because
they trusted the triple-A credit ratings assigned by agencies such as Moodys and Standard & Poors. This was
another mistake. Investors sought out these securitised products because they appeared to be relatively safe
while providing higher returns in a world of low interest rates.
Economists still disagree over whether these low rates were the result of central bankers mistakes or
broader shifts in the world economy. The surfeit of saving over investment in emerging economies, especially
China, flooded into safe American-government bonds, driving down interest rates.
Low interest rates created an incentive for banks, hedge funds and other investors to hunt for riskier
assets that offered higher returns. They also made it profitable for such outfits to borrow and use the extra cash
to amplify their investments, on the assumption that the returns would exceed the cost of borrowing. If shortterm interest rates are low but unstable, investors will hesitate before leveraging their bets. But if rates appear

stable, investors will take the risk of borrowing in the money markets to buy longer-dated, higher-yielding
securities. And that is indeed what happened.
From houses to money markets
When Americas housing market turned, a chain reaction exposed fragilities in the financial system.
Pooling and other clever financial engineering did not provide investors with the promised protection.
Mortgage-backed securities slumped in value, if they could be valued at all. Supposedly safe CDOs turned out
to be worthless, despite the ratings agencies seal of approval. It became difficult to sell suspect assets at
almost any price, or to use them as collateral for the short-term funding that so many banks relied on.
Trust, the ultimate glue of all financial systems, began to dissolve in 2007a year before Lehmans
bankruptcyas banks started questioning the viability of their counterparties. They and other sources of
wholesale funding began to withhold short-term credit, causing those most reliant on it to dissipate.
Complex chains of debt between counterparties were vulnerable to just one link breaking. The whole
system was revealed to have been built on flimsy foundations: banks had allowed their balance-sheets to bloat,
but set aside too little capital to absorb losses. In effect they had bet on themselves with borrowed money, a
gamble that had paid off in good times but proved catastrophic in bad.
Regulators asleep at the wheel
Failures in finance were at the heart of the crash. But bankers were not the only people to blame.
Central bankers and other regulators bear responsibility too, for mishandling the crisis, for failing to keep
economic imbalances in check and for failing to exercise proper oversight of financial institutions.
The regulators most dramatic error was to let Lehman Brothers go bankrupt, though the regulators
have already made mistakes long before the Lehman bankruptcy; most notably by tolerating global currentaccount imbalances and the housing bubbles that they helped to inflate. This bankruptcy multiplied the panic in
markets. Suddenly, nobody trusted anybody, so nobody would lend. Non-financial companies, unable to rely
on being able to borrow to pay suppliers or workers, froze spending in order to hoard cash, causing a seizure in
the real economy. Ironically, the decision to stand back and allow Lehman to go bankrupt resulted in more
government intervention, not less. To stem the consequent panic, regulators had to rescue scores of other
companies.
Central banks could have done more to address all this. The Fed made no attempt to stem the housing
bubble. The European Central Bank did nothing to restrain the credit surge on the periphery, believing
(wrongly) that current-account imbalances did not matter in a monetary union. The Bank of England, having
lost control over banking supervision when it was made independent in 1997, took a mistakenly narrow view
of its responsibility to maintain financial stability.
Under pressure from shareholders to increase returns, banks operated with minimal equity, leaving
them vulnerable if things went wrong. And from the mid-1990s they were allowed more and more to use their
own internal models to assess riskin effect setting their own capital requirements. Predictably, they judged
their assets to be ever safer, allowing balance-sheets to balloon without a commensurate rise in capital. The
Basel committee also did not make any rules regarding the share of a banks assets that should be liquid. And it
failed to set up a mechanism to allow a big international bank to go bust without causing the rest of the system
to seize up.
All in it together
The regulatory reforms that have since been pushed through at Basel read as an extended mea culpa (a
statement in which you say that something is your fault) by central bankers for getting things so grievously
wrong before the financial crisis. But regulators and bankers were not alone in making misjudgments. When
economies are doing well there are powerful political pressures not to rock the boat. With inflation at bay
central bankers could not appeal to their usual rationale for spoiling the party. The long period of economic and
price stability over which they presided encouraged risk-taking. And as so often in the history of financial
crashes, humble consumers also joined in the collective delusion that lasting prosperity could be built on everbigger piles of debt.